Some advisers and investors could be set for a nasty surprise when they receive their distribution statements for the 2008/09 financial year in a couple of months’ time. And I am not just talking about the “sea of red ink” on the total return line, with the S&P/ASX 300 Accumulation index already down by 30.5 per cent for the financial year to date; but the tax consequences they face could differ substantially across the Australian equity managed fund investments they hold.
Distribution statements sent by most fund managers will present total return as a combination of growth and distribution. The growth component comprises marked-to-market unrealised capital gains and has no tax implications until an investor decides to dispose of their units. The distribution return represents income and can consist of franked and unfranked dividends, interest income, withholding tax and discounted and non-discounted realised capital gains, each of which are taxed differently.
It’s worth remembering that managed funds are flow-through vehicles for the purposes of tax; that is, the tax liability falls upon the individual investor and is therefore paid at their own marginal tax rate. In addition, a trust must distribute all of the income and realised gains they earn in the financial year that it’s earned.
One of the key drivers which influence the growth/distribution split and ultimately the tax efficiency of returns to investors is the underlying investment strategy with regard to portfolio turnover. The accompanying table highlights the different portfolio turnover levels across an array of flagship Australian equity funds.
The effect of running high portfolio turnover is that it tends to be associated with a high proportion of realised capital gains and often non discounted capital gains. If a stock has been held for less than 12 months then it does not qualify for a capital gains discount that could otherwise be passed on to investors (50 per cent for individuals and trusts, 33.3 per cent for complying superannuation entities). A fund manager who runs a low level of portfolio turnover tends to be able to retain a higher level of unrealised gains and distribute mainly discounted capital gains.
What is interesting in the table is where Advance, Perennial and Perpetual sit relative to the peer universe. Historically, value-oriented investment style managers have been associated with lower portfolio turnover; but with the exception of Advance (also remembering this is a focused imputation fund), this margin appears to have narrowed. For example, Fortis (a growth oriented manager) has registered a lower level of portfolio turnover than both Perpetual and Perennial over the past 12 months. While in the most part this rule of thumb can be applied to value-oriented managers, it is incumbent on those investors seeking out active strategies with low portfolio turnover to “look beneath the covers” (albeit difficult to do) to ensure this holds true for the fund in which they are investing.
While index managers have been flying the flag for years on the importance of low portfolio turnover and its impact on after-tax performance, this is not simply an active versus passive argument. As the above table highlights, the variation in the level of portfolio turnover even amongst active managers can be significant. For example, the Advance Imputation Fund (managed by Maple Brown Abbott) for 13 straight years (FY 1996 – FY 2008) has delivered annual portfolio turnover of less than 10 per cent.
So while in a relative sense low-turnover strategies will be more attractive to high marginal rate taxpayers than they are to superannuation and pension funds (that is, lower level of realised capital gains and non discountable capital gains), strategies which seek to maximise franked income are ideally suited for low-rate taxpayers (that is, greater franking pick-up due to low tax rates).
To this end there has been the emergence of a new breed of Australian equity income funds, which may suit this investor profile, although they do need to look beyond the headline income yield and consider the tax efficiency of this income. Many of these funds are unlike the “old school” imputation style funds and typically access options (exchange traded and over the counter) and futures markets. While they all also have the “income” moniker in their fund names, most in part utilise a buy/write strategy. That is the purchasing of stock and writing (or selling) of call options over this stock. While this strategy “caps” upside stock price appreciation, it produces additional income through the option premium generated by selling call options.
Some of the players in this new segment of the market include the Zurich Investment Equity Income Fund, the Challenger Australian Share Income Fund, the Macquarie Australian equity Income Fund and the Aurora Sandringham Dividend Income Fund.
Zurich Investment Equity Income Fund
The Zurich Investment Equity Income Fund is managed by an external boutique fund manager by the name of Denning Pryce (High Denning & Michael Pryce). The fund has a “buy/write” strategy with disaster insurance. It runs a quasi index approach over its stock holdings, which largely comprise the ASX 50, writes (or sells) call options to generate additional income over 50 per cent of this portfolio and buys put options relatively deep “out of the money” (that is, a strike price significantly below the index or stock price at time of purchase) to protect against a market correction. The fund seeks to deliver an absolute 10 per cent per annum return through all market condition, is monthly income distributing and seeks to maintain net market exposure of 40 per cent to 60 per cent over time.
Challenger Australian Share Income Fund
The Challenger Australian Share Income Fund was launched in November 2005 and has been managed since this time by the current portfolio manager, Neil Margolis. The fund seeks to deliver investors a 2.0 per cent yield pick-up above that of the gross income of the S&P/ASX 300 Accumulation index while being defensively structured to deliver approximately 70 per cent of market volatility. Unlike the Zurich product, Challenger applies an active approach to stock selection, can invest in hybrid securities, but has a quarterly rather than a monthly distribution frequency.
Macquarie Australian Equity Income Fund
The Macquarie Australian Equity Income Fund (previously called the Macquarie Buy Write Fund) is more diverse by portfolio stock numbers than the above two mentioned peers (60 to 100 securities), seeks to have a large number of small bets through its enhanced index approach and is slightly more aggressive in its targeted yield pick-up (3 per cent versus 2 per cent for Challenger). While the fund adopts a buy/write strategy like its competitors, it doesn’t buy “out of the money” put options as part of its investment strategy as it believes this reduces the value of the fund over time. As a consequence, it will typically carry a higher level of net market exposure and doesn’t offer that downside protection.
Aurora Sandringham Dividend Income Fund
The Aurora Sandringham Dividend Income Fund is managed by Sandringham Capital and its investment philosophy is based around two relatively simple phenomena – that share prices strengthen relative to the market around the announcement of their earnings results; and on the ex-dividend date (that is, a security which no longer carries the right to the most recently declared dividend) the market does not fully price the value of franking credits. This is an ASX-listed investment and applications/redemptions can occur either on the ASX or via a monthly off-market facility at net tangible assets (NTA) per unit, plus or minus a buy/sell spread. The fund seeks to deliver cash plus 6.0 per cent per annum return and a strong and consistent half-yearly distribution. The investment process focuses on purchasing companies preannouncement and selling, following a qualifying 45-day-rule period, to ensure its entitlement to franking. The fund holds on average a concentrated portfolio of between five and 20 securities (predominantly the ASX top 30) and hedges up to 65 per cent of its stock purchases through the sale of SPI futures. The trust can be geared up to a maximum 100 per cent and the portfolio will typically be turned over six times per annum.
While tax efficiency of returns is an important consideration and investors should invest in the most appropriate vehicle so as to maximise their own outcome, it’s important to remember it’s a secondary consideration. No amount of tax uplift will make up for a poorly performing fund!